Adopt a Best-In-Class Operating Model Process Now

Executive Summary

Now that Q2 is closed and the board meetings are complete, it’s time to focus on the Operating Model Process - the annual budget. The Operating Model Process is a well-defined best practice that requires a small team and CFO leadership. 

A proper process conveys many benefits, including, 

• Increased management control over the business

• Enhanced reporting through a common language

• Improved morale because the process creates clear and actionable performance targets for all employees

• Better results in an M&A process because it’s easier for bidders to understand the business

All public companies and most institution-backed private companies employ the Operating Model Process because it increases the chances of business success.

Benefits of an Operating Model Process

Companies significantly benefit from maintaining an operating model that fosters trust among stakeholders, including investors, the board of directors, company executives, and all employees. The board relies on the model to assess company performance, allowing members to serve as strategic advisors. Executives regularly review the model to gain detailed insights into the company's performance, which fosters collaboration among departments. Knowledge of the operating model results will enable executives to exercise more control over spending. As a result, they feel more comfortable delegating decision-making responsibilities to employees in their respective chains of command, creating a more dynamic and entrepreneurial culture. Employees generally appreciate this trust, which boosts morale throughout the company. 

Below is a definition of terms associated with the operating model, along with an overview of best practices. 

The Operating Model and Process

Budgets

An operating model begins with a budget built by the company’s financial planning and analysis (FP&A) team in collaboration with all company departments over Q3 and approved by the board in late Q4. The FP&A team initiates the process with a “top-down” analysis, which shows the range of possible revenue growth based on the current business and development pipeline. The board and CEO often weigh in on the target revenue growth.  Once next year’s revenue is established, the FP&A team will complete a full set of financial statements, i.e., the statement of operations, the balance sheet, and the cash flow statement, using the revenue, percentage of revenue assumptions for expenses, and the resulting balance sheet and cash flow statement forecasts defined by operating performance assumptions. 

The next step is collaborating closely with all company departments to create a “bottom-up” analysis. The FP&A team will meet with each department to gather essential requirements, such as additional employees, operating expenses, and capital expenditures, to achieve the ” Top-down” revenue target. It’s crucial to bring all ideas forward so we can prioritize the most effective ways to meet the target and explore strategies to increase revenue. We typically finalize the bottom-up analysis by the end of the third quarter.

The FP&A team will compare the top-down and the bottom-up analyses to quantify the net cash flow variance. Typically, the revenue growth estimate does not support the spending requests. We expect this difference because we purposely requested all efficiency and growth initiatives. Now, we return to department meetings to prioritize initiatives and eliminate others, aiming to meet the cash flow target. This is challenging because departments are often forced to trade off their initiatives for the company's benefit, and this tradeoff process makes department targets and thus bonus plans more challenging to meet. The CFO provides leadership during this phase by negotiating the final numbers through close collaboration with the team. 

Now, the FP&A team has a final draft budget to present to the CEO and management. Once finalized, the CEO presents it to the board in late Q4 for approval before the end of the year. 

The board-approved budget outlines the available increases in employee compensation, including both merit-based raises and the standard cost-of-living adjustment. HR should conduct performance Reviews in November and December to allow managers to evaluate and grant merit-based raises to deserving employees while conveying the annual cost-of-living adjustments. Poorly performing employees should be terminated in January, making space for new hires as the budget dictates. 

With a board-approved budget, the FP&A team will model the next three to four years, referred to as the “Outyears.” While this exercise is mainly theoretical, the resulting outyear forecast will demonstrate how the company’s strategy will unfold over the coming years. This also presents an opportunity for executives to introduce inflection points. 

Forecasts

While the budget remains fixed, the FP&A group will produce monthly forecasts comparing actual results to the budget for the months to date and projections for future periods. The quarterly forecasts for the end of Q1, Q2, and Q3 are particularly important; these quarterly reports are referred to as the 3+9, 6+6, and 9+3 forecasts, respectively. The team will also generate updated annual forecasts in response to any significant changes in the business. 

As the year progresses, the accounting team will utilize the budget for budget-versus-actual (BVA) analyses. This process enables the team to identify shifts in spending, whether they are higher or lower. Elevated spending rates can adversely affect profitability, while decreased spending rates may pose challenges by indicating insufficient resources to meet budget objectives. Consequently, all variances are reported to the CFO for discussions with other executives. 

The Model

We collectively refer to the combined Budget and forecast, along with any associated scenarios, as the Model. It is also known as the Financial Model, Operating Model, or Operating Plan. Regardless of the terminology, it is the single source of truth for managing the company and demonstrating its performance to stakeholders.

Benefits

Board Meetings

Executives present the budget and future forecasts to the board for feedback and advice. A standardized presentation of the actual year-to-date results compared to the budget and future forecasts for the year provides a common language. This enables the board and executives to engage in important strategy discussions and avoid questions about how the numbers were calculated. 

Scenario Planning

Scenario planning is a crucial process that enables management teams to evaluate their decisions. When I ran Corporate Planning at Harrah’s Entertainment, now Caesars, we ran several scenarios each week, including buying a casino, selling a casino, building a casino, buying back shares, and refinancing debt.  

For every proposed development opportunity, the FP&A will use the budget and forecast as a baseline for modeling changes in the company’s resource allocation and corporate capitalization. Generating scenarios on demand and in real-time gives the company a competitive advantage when bidding on data center properties. The board will be able to assess and approve significant capital expenditures more efficiently because they will understand how the transaction aligns with the company’s strategic objectives. In my experience, scenario planning eliminates subjectivity, enabling decision-making based solely on facts. 

Recruiting 

When recruiting a CFO or other finance employees, candidates typically prefer to take on a role with a robust Operating Model Process because it reflects a degree of sophistication, enhancing the attractiveness of the career opportunity. Furthermore, the company will benefit as the candidates will become familiar with the business more rapidly. 

Employee Morale

I often hear company management criticize budgets, claiming that they inhibit creativity. However, organizations that operate without a budget can be more challenging for employees. 

In organizations that do not use a budget, resource allocations are often subjective and tend to favor executives with the loudest voices. Other departments are underresourced. This dynamic forces those employees to work harder with fewer resources, which feels unfair. A sense of unfairness leads to distrust among department employees, frustration with management, and, ultimately, poor morale and high turnover rates. 

The Operating Model Process gives employees confidence in management’s ability to lead the organization. 

Mergers and Acquisitions

Theoretically, any third party could review the budget and immediately understand the company’s performance. Thus, the company’s model plays a crucial role in mergers and acquisitions. Since the budget is grounded in the common language of financial models, all stakeholders —including investment bankers, lawyers, advisors, and our peers in the target company — can quickly grasp the levers that drive company performance. All parties rapidly align on the company’s performance, accelerating the time needed to close the deal while achieving the highest possible valuation. This is why the first request investment bankers make is, “Send us your model.”

Summary

All public companies and most institution-backed private companies employ the Operating Model Process because it increases the chances of business success. These companies invest in this process because the cost is small compared to the benefits.

About the Author

Eric Mersch has over 25 years of executive finance experience, including two stints as Chief Financial Officer of public companies. Eric is an FLG Partners equity partner who serves as an Interim CFO to venture and private equity portfolio companies, specializing in Strategy and Operations, Strategic Planning, equity and debt fundraising, Go-To-Market Strategies, financial planning and analysis, Business Intelligence, and accounting and control. He has worked with SaaS companies in the Big Data, Cybersecurity, Internet Infrastructure, Open-Source Software, Advertising/Marketing Technology, Mobile Application, Real Estate Technology, and Payment Processing spaces.

Previously, he served as Chief Financial Officer, Chief Accounting Officer, and VP, HR for ZipRealty, a publicly listed, real-estate technology company. In this role, he joined the management team during the dramatic turnaround and successful sale of the business to real estate conglomerate Realogy Holdings Corp (NYSE: RLGY) in 2014. While at ZipRealty, Eric played a key role in reorganizing corporate overhead, developing a new go-to-market strategy, and launching a new SaaS product. In his first public company role, he served as Chief Financial Officer for VitalStream (NASDAQ: VSTH), a Content Distribution Network (CDN) company that provided subscription-based data storage and streaming services to digital media companies. He introduced unit economic analysis and drove significant efficiencies in LTV/CAC. He managed due diligence in the company’s successful sale to Internap.

He also worked at Caesars Entertainment as Director Corporate Planning and later as VP, Finance for the Harrah’s and Flamingo Resorts, a $800 million revenue business. Before his civilian career, Eric served in the US Navy as a submarine officer on the USS Los Angeles. Eric holds an MBA from Harvard Business School and a Bachelor of Science in Economics from the U.S. Naval Academy and is a graduate of the US Navy’s Nuclear Power School.

In 2023, Eric published “Hacking SaaS: An Insider’s Guide to Managing Software Business Success.”